Optimal Dynamic Contracts with Environmental, Social and Governance Criteria

50 Pages Posted: 28 Jul 2020

See all articles by Jerome Detemple

Jerome Detemple

Boston University Questrom School of Business; Center for Interuniversity Research and Analysis on Organization (CIRANO)

Hao Xing

Boston University - Questrom School of Business

Date Written: July 2, 2020

Abstract

We examine dynamic contracts when output has negative environmental effects and the manager (agent) can invest to build up ESG capital and mitigate the externality. The incentive component of the optimal contract rewards based on cash flow and ESG capital when the principal is risk neutral; and it additionally loads on the production externality when the principal has CARA. Optimal ESG contracts are less sensitive to traditional pay-for-performance measures, and ESG investment is determined by the ratio of capital to cash flow exposure in the contract. We identify conditions under which ESG investment is optimal and improves welfare. We also examine constrained contracts controlling the agency friction associated with ESG investment.

Keywords: Principal-agent problem, hidden actions, externality, optimal contracts, environment, social responsibility, ESG capital, ESG investments, agency friction

JEL Classification: C61, C73, D82, J33

Suggested Citation

Detemple, Jerome and Xing, Hao, Optimal Dynamic Contracts with Environmental, Social and Governance Criteria (July 2, 2020). Available at SSRN: https://ssrn.com/abstract=3641603 or http://dx.doi.org/10.2139/ssrn.3641603

Jerome Detemple (Contact Author)

Boston University Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
(617) 353-4297 (Phone)
(617) 353 6667 (Fax)

Center for Interuniversity Research and Analysis on Organization (CIRANO)

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Montreal, Quebec H3C 3J7
Canada

Hao Xing

Boston University - Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

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